Irwin Mitchell | Quarter Day newsletter | New lease accounting rules explained

The impact of IFRS 16 - the new property accounting standard.

You might have thought that we all had enough to worry about as it is; Brexit, interest rate hikes, volatile politics, nerve agent poisoning, terror attacks and, with apologies to Chicken Licken, the sky falling on your head. But, if you are involved in commercial real estate, let’s add another.

With effect from 1 January 2019, the accounting profession will work to a new standard (IFRS 16) when dealing with commercial leases, following consultation with the International Accounting Standards body. This will fundamentally change how property is seen an investment, an asset and an operating vehicle.

How does this work?

The innocently titled “IFRS 16, Lease Accounting” will bring all property leases within the same regime as already applies to all other leases, such as finance leases. Put simply, (and what in accounting terms is ever simple?), from an accounting point of view, this means that expenditure under the leases (i.e. rent) will no longer be treated as a charge to the profit and loss account. Instead, the lease will be reflected on the balance sheet as an asset and liability, with the rental payment being replaced on the profit and loss account by a depreciation charge and interest. The depreciation charge will reduce the asset value over the term of the lease on the balance sheet and the interest charge will be front loaded in the profit and loss account.

You should also know that these accounting changes will apply to all leases, whether already in existence or otherwise. Given that, according to research by surveyors GVA, over 85% of these commitments would not appear on the balance sheet of a tenant company at the moment, we can expect to see a radical change in the look of the accounts of multi-site companies. This will be so whether or not tenants use a full retrospective approach, calculating the liability under the new standard as if it had applied from the start of the lease, or a modified approach calculating the liability based on the remaining non-cancellable term of the unavoidable lease payments. Tenants will be able to choose which approach to use for each lease, but have to state which approach is used in the notes to their accounts.

What difference will this make in practice?

All pretty technical so far. In three areas, that of landlord, tenant and banker, there will be substantial changes for all parties and risks to be reassessed. Going forward, and using the usual caveats that no one can really say what is going to happen, it is likely that:

Tenants will start asking for (and, indeed, have already started asking for) shorter leases, reducing the liability side on their balance sheet or, alternatively, inserting more frequent break clauses into longer leases. For shorter leases, this may be coupled with tenant options to renew on a contractual basis, rather than just relying on the statutory basis of the Landlord and Tenant Act 1954. They will also have to decide which of the two accounting approaches to take, and should consider this for each leasehold property. The directors of a tenant company will also have to consider what effect the changes to the balance sheet might have on the tenant’s solvency position, given that, as mentioned above, these leasehold liabilities appear on few balance sheets at the moment.
Landlords will see a detrimental effect on the capital value of the landlord’s own interest as leases become shorter. There are already examples where the effect of this on pre-lets is hampering the valuation of a Landlord’s prospective development, and, in some cases, is making the development unfundable. The accounting standard will have a direct effect on the market. And if more tenants look insolvent, this will affect the reversionary value too. At least, though, there should be fewer disputes as to the valuation of the landlord’s interest for voting purposes in any proposed CVA.
Lenders and borrowers alike will have to consider the very interesting aspect of banking covenants. Facilities granted to companies who are operating from leasehold properties will often have the ability to call an event of default if balance sheet ratios are broken. Given that the balance sheets will change under the new regime, everyone should be looking at banking arrangements to see whether the new accounting standards will place them in breach of those covenants. Similarly, Landlords borrowing money may also not only have covenants affecting their own interest, but also terms and conditions which restrict them letting to Tenants with weak financial figures themselves. Lenders will need to check their facility arrangement with their borrowers, whether these are landlords or tenants.

Every time the market changes disaster is predicted. Whether or not this matures into a disaster, we will have to wait and see. Fingers crossed that it doesn’t provide yet another layer of uncertainty to those already maturing in 2019.

This article first appeared in Co-Star in July 2018.

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Autumn 2018

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